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«Abstract Insider trading is one of the most controversial aspects of securities regulation, even among the law and economics community. One set of ...»

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On close examination, the argument for assigning the property right to the insider is considerably weaker than the argument for assigning it to the corporation. As we have seen, some have argued that legalized insider trading would be an appropriate compensation scheme. In other words, society might allow insiders to inside trade in order to give them greater incentives to develop new information. As we have also seen, however, this argument appears to founder on grounds that insider trading is an inefficient compensation scheme.

Even assuming that the change in stock price that results once the information is released accurately measures the value of the innovation, the insider’s trading profits are not correlated to the value of the information. This is so because his trading profits are limited not by the value of the information, but by the amount of shares the insider can purchase, which in turn depends mainly upon his ex ante wealth or access to credit.

A second objection to the compensation argument is the difficulty of restricting trading to those who produced the information. The costs of producing information normally are much greater than the costs of distributing it. Thus, many firm employees may trade on the information without having contributed to its production.

The third objection to insider trading as compensation is based on its contingent nature. If insider trading were legalized, the corporation would treat the right to inside trade as part of the manager’s compensation package.

Because the manager’s trading returns cannot be measured ex ante, however, the corporation cannot ensure that the manager’s compensation is commensurate with the value of her services.

The economic theory of property rights in information thus cannot justify assigning the property right to insiders rather than to the corporation. Because there is no avoiding the necessity of assigning the property right to the information in question to one of the relevant parties, the argument for assigning it to the corporation therefore should prevail.

D. Open Questions

If the property rights justification for regulating insider trading is accepted, several questions remain open. Among these are: (1) Should the insider trading prohibition apply to all confidential information relating to the firm, or only to information whose use by an insider poses some serious threat of injury to the corporation? (2) Should the insider trading regulatory scheme consist of a 5650 Insider Trading 795 mandatory prohibition or a default rule? (3) In the United States, the regulatory purview of the federal securities laws is normally regarded as being limited to issues of disclosure and fraud. Questions of theft and fiduciary duty are usually relegated to state law. Why is insider trading an exception to that scheme? We consider these questions seriatim.

21. Scope of the Prohibition

In Diamond v. Oreamuno the New York (state) Court of Appeals concluded that a shareholder could properly bring a derivative action against corporate officers who had traded in the corporations stock. The court explicitly relied on a property rights-based justification for its holding: ‘The primary concern, in a case such as this, is not to determine whether the corporation has been damaged, but to decide, as between the corporation and the defendants, who has a higher claim to the proceeds derived from exploitation of the information.’ Critics of Diamond have frequently pointed out that the corporation could not have used the information at issue in that case for its own profit. The defendants had sold shares on the basis of inside information about a substantial decline in the firm’s earnings. Once released, the information caused the corporation’s stock price to decline precipitously. The information was thus a historical accounting fact of no value to the corporation. The only possible use to which the corporation could have put this information was by trading in its own stock, which it could not have done without violating the antifraud rules of the federal securities laws.

The Diamond case thus rests on an implicit assumption that, as between the firm and its agents, all confidential information about the firm is an asset of the corporation. Critics of Diamond contend that this assumption puts the cart before the horse: the proper question is to ask whether the insiders use of the information posed a substantial threat of harm to the corporation. Only if that question is answered in the affirmative should the information be deemed an asset of the corporation (see, for example, Freeman v. Decio).

Proponents of a more expansive prohibition might respond to this argument in two ways. First, they might reiterate that, as between the firm and its agents, there is no basis for assigning the property right to the agent. See above, Section 20. Second, they might focus on the secondary and tertiary costs of a prohibition that encompassed only information whose use posed a significant threat of harm to the corporation. A regime premised on actual proof of injury to the corporation would be expensive to enforce, would provide little certainty or predictability for those who trade, and might provide agents with perverse incentives.

796 Insider Trading 5650

22. Mandatory or Default Rules

For law and economics supporters of the insider trading prohibition, an interesting question is whether the corporate employer should be allowed to authorize its agents to inside trade. Because most property rights are freely alienable, treating confidential information as a species of property suggests that the information’s owner is presumptively entitled to decide whether someone may use it to inside trade. In other words, the insider trading prohibition arguably should be treated as simply a special case of the laws against theft.





Another way of phrasing the question is to ask whether the prohibition of insider trading should be a default or a mandatory rule. Default rules in corporate law are analogous to alienable property rights. Just as shareholders generally are protected by the doctrine of limited liability unless they give a personal guarantee of the corporation’s debts, patentholders have exclusive rights to their inventions unless they authorize another’s use by granting a license. Continuing the analogy, mandatory rules in corporate law are comparable to inalienable property rights. Just as corporate law proscribes vote buying, the law prohibits one from selling one’s vote in a presidential election.

So phrased, the insider trading problem becomes a subset of one of the fiercest debates in the corporate law academy; namely, the extent to which mandatory rules are appropriate in corporate law. A detailed analysis of this debate is beyond this chapter’s scope. Accordingly, it perhaps suffices to observe that the question of whether the insider trading prohibition should be cast as an alienable or an inalienable property right remains open (see generally Fischel, 1984; Macey, 1984; Ule, 1993).

23. How Should Insider Trading be Regulated?

Even among those who agree that insider trading should be regulated on property rights grounds, there is no agreement as to how insider trading should be regulated. Bainbridge (1995, pp. 1262-1266) contends that the federal Securities and Exchange Commission has a comparative advantage in prosecuting insider trading questions, which justifies treating the prohibition as a matter of concern for the federal securities laws. Macey (1991, pp. 40-41) agrees that insider trading is difficult to detect and, moreover, that centralized monitoring of insider trading by the SEC and the self-regulatory organizations within the securities industry may be more efficient than private party efforts to detect insider trading. He nevertheless draws a distinction between SEC monitoring of insider trading and a federal prohibition of insider trading.

Macey contends that the SEC should monitor insider trading, but refer detected 5650 Insider Trading 797 cases to the affected corporation for private prosecution. A third option, favored by some commentators, would be to leave insider trading to state corporate law, just as is done with every other duty of loyalty violation and, accordingly, divest the federal SEC of any regulatory involvement. Although this debate has considerable theoretical interest, it is essentially mooted by the public choice arguments recounted in Section 10 above. There is no constituency that would support repealing the federal insider trading prohibition, while proposals to do so would meet strong opposition from the SEC and its securities industry constituencies that benefit from the current prohibition.

24. Some Suggestions for Further Empirical Research

Those who approach the insider trading proposition assuming that the property right to inside information belongs to managers in the absence of a compelling reason for assigning it to firms will necessarily draw different conclusions than those who start out with the opposite assumption. Unfortunately, in the absence of decisive empirical evidence, the insider trading debate turns on who gets to choose the null hypothesis - the proposition that the other side must refute - and on that issue there is unlikely to be agreement.

The problem is that serious empirical research on insider trading is obviously impeded by the subject matters illegality. The two principal sources of raw data for US transactions are insider stock transaction reports filed under Securities Act Section 16(a) and case files of actions brought under Securities Exchange Act Rules 10b-5 and 14e-3. The first option is unattractive for two reasons: (1) only a small percentage of individuals with access to inside information are obliged to file under Section 16(a); and (2) it seems unlikely that insiders would knowingly report the most interesting transactions - those that violate Rules 10b-5 or 14e-3.

The second option is unattractive because of the potential for selection bias.

Many insider trading cases result from computer analysis of stock market activity. As such, empirical studies of SEC case files will be inherently biased towards cases in which insider trading conincident with noticeable price or volume effects.

A third option is cross-cultural studies, focusing on stock markets operating in countries where insider trading is either legal or not vigorously prosecuted.

One must be careful, of course, to ensure that focusing on only one aspect of cross-cultural comparisons does not invalidate the results.

Having said all of that, there remain several areas in which further empirical research might be helpful. First, the data on the price and volume effects of insider trading remain confused. Further research on this issue seems 798 Insider Trading 5650 warranted. A related area of research would focus on the incentive effects of insider trading by corporate managers. Is there any empirical basis for the compensation argument?

Second, it would be helpful to gather better data on the effect of insider trading on investor confidence. Here is one area in which cross-cultural comparisons are both promising and yet fraught with danger. As Macey (1991, p. 44) observes, Japan only recently began regulating insider trading and its rules are not enforced. Hong Kong has repealed its insider trading prohibition.

Yet, both have vigorous and highly liquid stock markets. The question is to what extent the Japanese and Hong Kong experiences are relevant to an understanding of US capital markets. Assuming the validity of such comparisons, however, studying the effects of insider trading regulation (or the lack thereof) on other markets would be instructive with respect to the panoply of questions relating to investor confidence and injury.

Acknowledgments

Although any remaining errors are my sole responsibility, I wish to thank Mitu Gulati and William Klein, both Professors of Law at UCLA, Lisa Meulbroek, Associate Professor at the Harvard Business School, and Thomas Ulen, Professor of Law and Economics at the University of Illinois, as well as the two anonymous referees, for helpful comments on earlier drafts. I also wish to thank my research assistant, Bradley Cebeci, for his excellent work in helping to assemble the bibliography.

Bibliography on Insider Trading (5650)

Agrawal, Arun and Jaffe, J. (1995), ‘Does Section 16b Deter Insider Trading by Target Managers?’, 39 Journal of Financial Economics, 295-319.



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